401(k)s: The Great American Risk Transfer
Last night's "60 Minutes" segment on 401(k) plans (see following video) highlighted the high fees in 401(k) and other employer-sponsored retirement accounts. While helping participants understand the fees they pay is laudable, there's a bigger problem with 401(k)s: the switch from pension plans to 401(k)s was the largest risk transfer in the history of the U.S. More on that in the second video, below.
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Instead of companies bearing 100 percent of the retirement funding burden, the advent of 401(k) plans meant that employees would be primarily responsible for their own retirement saving. Here's how it happened and what we need to do to address the problem.
In the late seventies/early eighties, U.S. companies were struggling to stay afloat. Like the automakers today, corporate America was contending with a broken operating model that had become outdated and less competitive in the world. Adding to the pressure on the bottom line was the cost of operating and funding pension plans, especially for smaller companies.
In that difficult environment, benefits consultant Ted Benna was attempting to help a bank with its compensation packages when he realized that a broad definition of paragraph (k) of Section 401 in the US tax code might allow his client to change compensation for its employees. Benna's broad interpretation of IRS Section 401, paragraph (k) became a means for employees to defer part of their own salaries on a pre-tax basis. Employers would provide a match on employee contributions to create an incentive for participation.
Under Benna's plan, employees would still save for retirement, but would do so primarily on their own, with little assistance from their employers. I like to refer to this period as the "Great Risk Transfer" because when 401(k) plans were introduced, employees now had to bear the majority of risk for their retirement assets.
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In 1981, after Benna designed the first pre-tax salary deferral 401(k) plan, the IRS issued proposed regulations on Section 401(k) that officially sanctioned pre-tax salary reductions. The fully-funded private company pension plan was about to become nearly extinct.
You might have thought that the elimination of pension plans would cause a revolution among U.S. workers. The reason it did not was one part luck and one part marketing.
As 401(k) plans were rolled out, the stock market was recovering after a long and painful stretch (from 1966-1982, stock investors actually lost money after factoring in inflation). In a page from "it's better to be lucky than good," the introduction of 401(k)'s was the ultimate in market timing: the plans took hold at the beginning of the biggest bull market in history for stocks and bonds. The marketing aspect was a combination of greed (your boring old pension plan can't compare with the spectacular returns of the United States financial markets!) and a call for increased personal responsibility that could empower all workers (not just the rich ones) to control their financial destinies.
It was a stunning success. The new 401(k) plans introduced millions of Americans to the concept of investing. The problem was that many retirement plan participants failed to understand exactly what they were buying and had little comprehension for the risks involved with the activity called "investing". How could they? Month after month, year after year, investors saw their retirement plan assets grow and every time the market ran into a rough patch, it would recover quickly.
Investors became accustomed to making money and believed every one of the charts, articles and books that demonstrated the long-term attractiveness of holding stocks for the long-term. As a result, there was a diminished respect for risk, which along with a resurgent economy, masked the risks that participants were bearing every day. Adding to the problem was the fact that most participants were not properly educated in even the most basic investing concepts.
To address the continuing problem, lawmakers should make mandatory training an essential component of retirement plans. Until that time, participants need to pay more attention and educate themselves.
